Is Exchange Income Corporation (TSE:EIF) Trading At A 31% Discount?

Key Insights

• Exchange Income's estimated fair value is CA$78.73 based on 2 Stage Free Cash Flow to Equity

• Current share price of CA$54.54 suggests Exchange Income is potentially 31% undervalued

• Our fair value estimate is 24% higher than Exchange Income's analyst price target of CA$63.27

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Exchange Income Corporation (TSE:EIF) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Exchange Income

The Model

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CA$, Millions)	CA$189.1m	CA$222.5m	CA$227.3m	CA$231.6m	CA$235.9m	CA$240.3m	CA$244.6m	CA$249.0m	CA$253.4m	CA$257.9m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x1	Est @ 1.91%	Est @ 1.86%	Est @ 1.83%	Est @ 1.81%	Est @ 1.79%	Est @ 1.78%	Est @ 1.78%
Present Value (CA$, Millions) Discounted @ 8.3%	CA$175	CA$190	CA$179	CA$169	CA$159	CA$149	CA$140	CA$132	CA$124	CA$117

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.5b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 8.3%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$258m× (1 + 1.8%) ÷ (8.3%– 1.8%) = CA$4.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$4.0b÷ ( 1 + 8.3%)¹⁰= CA$1.8b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CA$3.4b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$54.5, the company appears quite undervalued at a 31% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Exchange Income as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.3%, which is based on a levered beta of 1.094. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Exchange Income

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings and cashflows.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Airlines market.

• Shareholders have been diluted in the past year.

Opportunity

• Annual earnings are forecast to grow faster than the Canadian market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Paying a dividend but company has no free cash flows.

• Revenue is forecast to grow slower than 20% per year.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Exchange Income, there are three pertinent aspects you should explore:

1. Risks: Every company has them, and we've spotted 3 warning signs for Exchange Income you should know about.

2. Future Earnings: How does EIF's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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